India: Startup Funding: All You Want To Know About Term Sheets

Startups and funding go hand-in-hand. First-time entrepreneurs
are keen to bring angel investors and VC funds on board. That's
when all the documentation and legalities come into the picture.
Several entrepreneurs find it difficult to understand legal
documents. One such document is the 'term sheet'. Vijay
Sambamurthi, founder and managing partner at law firm Lexygen,
explains the 'term sheet' in its entirety and what
entrepreneurs must bear in mind before signing this document.

Term Sheet

A term sheet is basically a non-binding document. Apart from two
or three clauses - like those relating to exclusivity,
confidentiality and governing law - the other provisions in the
term sheet do not constitute a binding contract. The idea of a term
sheet is to say that the parties – founders and investors
– have, after discussions, reached a stage where they have a
preliminary level of comfort with each other. It's a broad,
in-principle agreement relating to the key deal terms, including
the valuation.

The term sheet codifies the discussions and includes things the
parties have agreed to informally, not legally. Subsequent to the
term sheet, there will be a due diligence process and the parties
will eventually negotiate, agree on, and sign the definitive
agreements. The signing of these definitive agreements is when a
binding obligation to do the deal is formally created. So, a term
sheet creates no contractual obligations on the investor to invest
and on the company to issue shares to the investor.

Most terms in a term sheet are pretty standard and have evolved
as "market practice" over many years of deal-making. It
typically contains the details of who the investor is; name and
identities of the investors and founders; the pre-money valuation
of the company (as that is what determines how much equity stake
the investor gets for certain amount of money); investment amount;
whether the investors are going to get a board seat, and then a
whole lot of special rights such as veto rights and affirmative
rights.

Be careful with affirmative vote, liquidation preference
clauses

Below are some the important clauses of a typical angel or VC
term sheet that entrepreneurs should pay close attention to:

Affirmative vote means that unless the investors vote in favour
of a particular matter, the company cannot approve such an action.
While each VC or angel investor may have its own critical items
when it comes to matters requiring the investor's affirmative
vote, the typical rights seen in most such deals include amendment
of articles of the company, change in composition of the board of
directors, share issuances at lower price than investors' entry
price, and change of statutory auditors. These are matters which
can materially affect the rights of the investors.

Liquidation preference essentially means that in a scenario
where either the company gets wound up or sold, the investors will
get paid, before everyone else, a certain amount. What this amount
should be is a matter of negotiation between the company and the
investor, but most investors I know ask for a return of the
investment amount along with any accrued and unpaid dividends. This
can be seen as a "principal protection" right. In some
cases the liquidation preference can get much more complex than a
simple 1x return. Some VCs may even ask for 2x plus or 1x plus
certain high internal rate of return (IRR). There are various ways
one can structure this, but the basic concept behind a liquidation
preference is that "the investors should get their money plus
some return back, before the founders can get anything".

These are often referred to in industry parlance as
'downside protection' clauses and are meant to protect the
investors from the adverse consequences of downside events (like a
sale of the company at a valuation lower than investors' entry
valuation, for example) to the investor. But there are times when
investor protection becomes almost like a guaranteed IRR and
that's where the debate starts on whether a liquidation
preference is really fair. Entrepreneurs, therefore, need to be
careful about such clauses.

Founders' ownership: In early-stage angel, seed or VC deals,
this is a very important issue to be addressed in the term sheet
and definitive agreements. In a late-stage company, the ownership
of the founders is pretty much cast in stone. But in early-stage
startups, the founders' ownership is very dynamic as the VC is
investing at a time when the risk is too high not only of the
venture failing but also of the founders losing focus on the
venture.

In order to keep the founders focused and committed, investors
often put in restrictions on the founders' ownership. This
works somewhat like a stock option plan where the founders start
with a certain percentage stake and the remaining stake of the
founders will be released to them over a specified period.
Investors don't want a situation where they have funded a
company, only to find one or more of the founders quitting or
losing commitment soon thereafter, and continuing to sit on a 50
per cent ownership in the company! The idea is to hold the founders
accountable.

At the same time, founders should be careful and be comfortable
that the founder vesting schedule proposed by the investors is not
too harsh on the founders. Investors, too, need to be fair with the
founders while still having an effective mechanism to hold them
accountable.

Restrictions on transferability are very common in VC term
sheets. Usually, VCs will come in and tell founders not to sell
their shares in the company until investors exit. However, founders
may want to be able to sell a certain portion of their stock to be
able to meet personal expenditure. So, in a term sheet, parties
often agree that founders can sell up to a certain percentage of
their holding, and there's a lock-in period agreed to of, say,
three to four years for the remaining founder equity.

The exit clause is an important and interesting one. This clause
requires the founders to commit to deliver an exit – either
by an IPO or through an M&A deal – to the investors by a
certain date. If that doesn't happen, this clause would
typically require the founders to buy back the shares held by the
investors at a price that delivers a guaranteed IRR to the
investors. Many entrepreneurs make the mistake of not giving enough
importance to this clause either because they feel supremely
confident that they would be able to deliver an exit or because
"the whole thing is so far away in time anyway"!

As bullish and confident as entrepreneurs need to be to succeed,
when it comes to signing up to obligations like this, they need to
give it a lot of thought. I have seen term sheets where the
founders had agreed to buy back the investor's shares at a
price that would deliver an IRR of 40 per cent, and frankly, I have
been shocked at such clauses. One thing for founders to chew on
while signing up to these clauses is this – when you commit
to an IRR guarantee, remember that it is going to get progressively
tougher to deliver that exit the further away in time that an exit
event is – it is MUCH TOUGHER to deliver a 25 per cent IRR
IPO five years from an investment than to do so three years from
the date of the investment.

Types of early-stage financing deals

There are, broadly speaking, two kinds of deals in the
early-stage ecosystem. One is a simple preferred/equity deal and
the other is what is referred to as a "convertible note
deal". In a simple preferred/equity deal, the valuation (or at
least the base case valuation) is locked in upfront and hence, the
investor is coming in at a certain value and issued shares on day
one. Even in a simple preferred/equity deal, the valuation could be
subject to a reset based on certain milestones and contingencies,
but there is a valuation agreed upon when the investor invests the
money, and the investor is committed to staying invested in the
company for a reasonable period.

In an early-stage (pre-Series A) deal, the convertible note
structure is common not only in Silicon Valley but also
increasingly in India. In such deals, the investor agrees to invest
based on the potential in the venture, but is unsure about the
valuation that can be ascribed to the startup. Therefore, the
investor invests an agreed amount of money into the company and
receives "convertible notes" of the company in return
(and no shares of the company on day one). The convertible note
would, under its terms, convert into equity shares of the company
at a valuation that is at a discount to the next round of funding
raised by the company. The usual discounts to the next round
valuation that the convertible note holders would get could vary
from 10 per cent to 20 per cent. Convertible deals are more common
in angel and seed rounds, and not so common in Series A rounds.

What makes it all so complicated for entrepreneurs?

It is complicated because these founders are dealing with
sophisticated investors. While entrepreneurs can find all this
daunting, at the end of the day they will find the term sheet not
just protects the rights of the investors but equally protects
their own rights as well. Entrepreneurs deal with sophisticated
investors who invest based on clear mandates and principles. Most
importantly, the investors have a duty to manage other people's
money – which is why they have to be more careful on how they
deploy their money. So, investors come up with certain safeguards
to protect themselves, and those principles get captured in a term
sheet and eventually in the rest of the documents.

Entrepreneurs can often find all this daunting because they have
not done this before. Some of them may not even think all this to
be important enough in comparison to the more exciting task of
building their businesses. However, entrepreneurs must appreciate
that high-quality legal documentation is an absolute necessity to
ensure that they protect their rights and control over the business
that they are working so passionately to grow. Poor or one-sided
financing documents can cause operational hardship and even
financial leakages to founders even where they have built
successful companies.

How to ensure water-tight term sheet

First and foremost, investors as well as founders should get
top-notch legal advice. You wouldn't hesitate to spend good
money on getting the best doctors, so why would you not take the
same approach when it comes to picking your legal advisors for
something that is such an important part of your life – your
startup! Most times, founders feel they can draft their own term
sheet as there are "open source" type templates available
online. May be they can and many of them even have pretty good
drafting skills. However, it's not about the template but about
getting top-notch advice. Good counsel doesn't only mean
drafting a document that works, but it's about having good
quality advice at the table for a founder at the time when he is
structuring a deal with the investor. Simply put, founders need
somebody on the legal side advising and mentoring them.

Suggestions for founders and investors

For founders

– It is, of course, important to guard yourself against
signing up to unfair terms. Equally, try to understand what the
standard market practice for such deals is, so that you don't
end up baulking at every other term in the term sheet that
(wrongly) seems so unreasonable to you at first glance. Founders
should understand that while some clauses may, prima facie, appear
unfair, they are "standard market practice" for a good
reason. Founders must make efforts to understand the intent behind
each of these clauses, and seek advice from their legal counsel as
to whether specific proposals in the term sheet offered by an
investor are standard market practice or not.

– I find that Indian founders often get too obsessed about
their notions of control and ownership of their startup, and this
obsession impedes their ability to think optimally when they are
raising funds. The point is they have to make a wise choice between
excess dilution and under-dilution; they have to make optimal
dilution. It is obviously better to own 10 per cent of a unicorn
than to own 100 per cent of a $1 million company – and it is
usually much easier to create unicorns by diluting more equity and
more often.

– Pay special attention to the liquidation preference
clause. There are lots of investors who are absolutely fair with
entrepreneurs, but there are some who ask for highly unfair
liquidation preference clauses. An onerous liquidation preference
clause can pretty much wipe out all value for the founders in
certain circumstances.
– Keep a pragmatic approach on funding. Keep your focus on
closing the deal fast and don't overdo the posturing and
negotiations – there's your business straining at the
leash to grow and you have to go back quick to taking care of it!
So, don't get dogmatic in your approach.

For investors

– Some times, because of their higher position on the food
chain, investors can become tempted for
"over-protection". While I think it is fair to provide
the investors with multiple layers of protection to address fair
risks, it is not fair at all to seek unreasonable or unfair levels
of economic and other rights in the garb of "downside
protection". It is my belief that successful investors win
more by being fair and balanced in their dealings with founders
than do by being too harsh. There should not be patent signs of
unfairness in the term sheets that they offer.

– Again, I have realised from my experience advising
scores of investors that the consistently successful ones don't
just bulldoze the founders to get their way on deal terms, but make
the effort to explain to them why those clauses are important and
fair, and get the buy-in of the founders to those clauses.

Lastly, it is in your interests and the interests of your deal
to ensure that the founders get their own legal counsel who is
experienced in VC deals. This will save you and your legal counsel
the trouble (and cost) of explaining each and every clause in the
term sheet to the founders.

The RBI, on September 1, 2018, released a user manual to clearly set out the procedure for filing a single master form, which it introduced on June 7, 2018, to integrate the existing reporting norms for foreign investment in India.

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